Problem
Faulpeltz Gmbh. is a German subsidiary of Lazy Ltd., a British MNC. Faulpeltz is considering a 5-year project in Germany that requires an initial investment of 1,360 million Euros (EU). The project will generate cash flows of EU 450 million per year in the years 1 to 4 and EU 575 million at the end of year 5. The required rate of return for projects of similar risk in Germany is 10%, and in the U.K. is 12%. The annual inflation rate in Germany is expected to be 4.5% for the next several years. British (annual) inflation is expected to be 2.5%. The current spot exchange rate is 0.65 £/EU.
a) Calculate the NPV in £-terms from the project's (Faulpeltz Gmbh.) point of view.
b) Calculate the NPV in £-terms from the parent's (Lazy Ltd.) point of view.
c) What is your recommendation to Lazy's managers in terms of whether they should accept or reject the project?
d) Should Lazy's managers try to hedge the EU projected cash flows? Why/why not?